Since the advent of the international debt crisis in the early 1980s, many developing countries have been striving to stabilize and adjust their economies. More recently, Eastern European countries and states of the former Soviet Union have been facing an equally challenging task: to achieve domestic and external stability while simultaneously transforming their economies from central planning to market-oriented systems. Some countries have undertaken adjustment and reform on their own, but many others have embraced stabilization and structural programs endorsed by the International Monetary Fund, the World Bank, and other institutions. As a result, there has been a very substantial increase in the number of countries implementing stabilization and reform programs under IMF arrangements during the past decade, as well as in the level of financial resources committed by international organizations and bilateral donors. The widespread recourse to these programs by developing countries is unlikely to abate in the near future. Although considerable progress has been achieved in resolving the debt crisis of the middle-income countries, many low-income developing countries, as well as formerly socialist economies, are now initiating adjustment and seeking financial assistance. It is, therefore, a propitious time to examine the role that external institutions can play in assisting an adjusting country and to ascertain the general factors that can influence the success or failure of such programs.
For the adjusting nations and for the international institutions that have been involved in the process, there are many interesting lessons to be drawn from past experience. One episode that is particularly rich in insights for today’s adjustment efforts is the currency stabilizations that were implemented by a number of European countries during the 1920s. Most of the features of these post-World War I European stabilizations have already been extensively discussed in the literature.1 Yet a central aspect of these episodes, which has received much less discussion, is the extent of foreign assistance and external enforcement that were involved in these early but comprehensive macroeconomic adjustment programs.
During the 1920s, six European countries undertook macroeconomic adjustment programs under the auspices of the League of Nations: Austria, Hungary, Greece, Bulgaria, Estonia, and Danzig.2 Why did these countries resort to the League for external enforcement of their currency stabilization programs, while others, in fact the majority of the European countries, stabilized their currencies without recourse to external loans or the discipline of the League? This paper addresses some issues that are raised by this question and their relevance for current adjustment programs. The paper’s central purpose, then, is to examine the role that an external institution can play in adjustment—in particular, the effectiveness of the League of Nations in enforcing and making credible the stabilization programs it endorsed during the 1920s.
To tackle these issues, the paper first reviews the theoretical justification for an external agent’s intervention in a macroeconomic adjustment program. The paper discusses a number of arguments that go beyond the standard explanation, which has focused almost exclusively on the technical advice and financial support that external institutions can provide. The paper finds that credibility and financing problems play an important role in explaining reliance on external institutions. A major reason why countries may seek external intervention is that they lack the credibility or “reputation” needed to ensure the success of their stabilization efforts. An external agent may be able to provide a “commitment technology” that enhances the credibility of the program. The credibility problem and the role of external enforcement are illustrated with a simple model. In particular, the paper argues that the extent of nominal instability is likely to be an important determinant of external participation in a stabilization program.
Once the theoretical framework has been outlined, the paper analyzes the experience with stabilization programs endorsed by the League of Nations during the 1920s. The comprehensiveness of the economic reforms is emphasized. A brief analysis of the general macroeconomic accomplishments of the programs is also presented. Furthermore, because the credibility of the commitment to stabilize the economy appears to have been a crucial element in a program’s success, this paper places special emphasis on the instruments of control that the League of Nations employed to enforce its programs. A program that is not expected to be enforced will not be credible; in turn, a non credible stabilization program is less likely to be successful. An empirical assessment of the enforcement by the League is undertaken based on the outcomes of several programs.
By contrasting the European currency stabilizations that had recourse to external enforcement with those that did not, the paper attempts to test the theoretical explanations that have been offered for the reliance of some adjusting countries on external institutions. The paper presents empirical evidence to support the view that enhancing credibility and resolving financing problems were important determinants of a nation’s decision to rely on an external agent to carry out its stabilization.
Policy implications can be drawn from this experience for both countries and external agents. The importance of fiscal adjustment and monetary discipline are confirmed by these episodes. In addition, the experience of the 1920s highlights the necessity of undertaking fundamental institutional reform to establish macroeconomic stability. The analysis suggests that the League of Nations enforced such regime changes with remarkable success.
Barro, Robert, “Reputation in a Model of Monetary Policy with Incomplete Information,” Journal of Monetary Economics, Vol. 17 (1986), pp. 3–20.
Barro, Robert, and David Gordon (1983a), “A Positive Theory of Monetary Policy in a Natural Rate Model,” Journal of Political Economy, Vol. 91 (1983), pp. 589–609.
Barro, Robert, and David Gordon (1983b), “Rules, Discretion and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics, Vol. 12 (1983). pp. 101–22.
Blackburn, Keith, and Michael Christensen, “Monetary Policy and Policy Credibility: Theories and Evidence,” Journal of Economic Literature. Vol. 27 (1989), pp. 1–45.
Cagan, Phillip, “The Monetary Dynamics of Hyperinflation.” in Studies in the Quantity Theory of Money, ed. by Milton Friedman (Chicago: University of Chicago Press, 1956).
De Bordes, Jan van Walre Austrian Crown: Its Depreciation and Stabilization (London: P.S. King, 1924: reprinted bv Garland Publishing, New York, 1983).
Dominguez, Kathyrn, “Role of International Organizations in the Bretton Woods System,” in A Retrospective on the Bretton Woods System, ed. by Michael Bordo Barry Eichengreen (Chicago: University of Chicago Press, for NBER, 1993).
Dornbusch, Rudiger, “Monetary Problems of Post-Communism: Lessons from the End of the Austro-Hungarian Empire,” Weltwirtschaftliches Archiv. Vol. 28 (1992), pp. 391–424.
Dornbusch, Rudiger, and Stanley Fischer, “Stopping Hyperinflations Past and Present,” Weltwinschafttiches Archiv, Vol. 122 (1986), pp. 1–47.
Dornbusch, Rudiger, Federico Sturzenegger. and Holger Wolf, “Extreme Inflation: Dynamics and Stabilization,” Brookings Papers on Economic Activity, Vol. 2 (1990), pp. 1–64.
Edwards, Sebastian, “The International Monetary Fund and the Developing Countries: A Critical Evaluation,” Carnegie-Rochester Conference Series on Public Policy, Vol. 31 (1989), pp. 7–68.
Eichengreen, Barry, Golden Fetters: The Cold Standard and the Great Depression 1919-1939 (New York: Oxford University Press, 1992).
Fischer, Stanley, “Dynamic Inconsistency, Cooperation and the Benevolent Dissembling Government,” Journal of Economic Dynamics and Control, Vol. 2 (1980), pp. 93–107.
Garber, Peter, and Michael Spencer, “The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform,” IMF Working Paper 92/66(Washington: International Monetary Fund, 1992).
Harberger, Arnold, and Sebastian Edwards, “International Evidence on the Sources of Inflation” (unpublished; University of Chicago, 1980).
Heymann, Daniel, “Las Grandes lnflaciones: Características y Estabilización,” in Tres Ensayos sobre Inflación y Estabilización (Buenos Aires: CEPAL, 1986).
Kydland, Finn, and Edward Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, Vol. 85 (1977), pp. 473–91.
League of Nations, Principles and Methods of Financial Reconstruction Work Undertaken Under the Auspices of the League of Nations (Geneva: Secretariat of the League of Nations, 1930).
League of Nations, The League of Nations Reconstruction Schemes in the Inter-war Period(Geneva: Publications Department of the League of Nations, 1945).
Leijonhufvud, Axel, “Keynesianism, Monetarism and Rational Expectations: Some Reflections and Conjectures” in Individual Forecasting and Aggregate Outcomes, ed. by Roman Frydman and Edmund Phelps (New York: Cambridge University Press, 1983).
Llach, Juan, “La Naturaleza Institucional e Internacional de las Hiperestabiliza-ciones,” Desarrollo Ecónmico, Vol. 26 (1987), pp. 527–59.
Pietri, Nicole, “L’œuvre dun Organisme Technique de la Societé des Nations: Le Comité Financier et la Reconstrution de IAutriche (1921-1926),” in The League of Nations in Retrospect (Berlin: Walter de Gruyter, 1983).
Sachs, Jeffrey, “Conditionality, Debt Relief, and the Developing Country Debt Crisis,” in Developing Country Debt and Economic Performance, ed. by Jeffrey Sachs (Chicago: University of Chicago Press, for NBER, 1989).
Schacht, Hjalmar, “The New German Currency” in European Currency and Finance, ed. by John Young (Washington: Commission of Gold and Silver Inquiry, U.S. Senate, 1925).
Julio A. Santaella is an Economist in the Research Department, He holds a Ph. D. from the University of California, Los Angeles. This paper draws on two chapters of the author’s Ph. D. dissertation. Comments by Sebastian Edwards, Jeffrey Frieden, Arnold Harberger, Daniel Heymann, Malcolm Knight, Axel Leijonhufvud, Kenneth Sokoloff, and Jean-Leaurant Rosenthal are gratefully acknowledged.
Dorrtbusch, Sturzenegger. and Wolf (1990) describe these issues. In this section, the terms stabilization and adjustment are used interchangeably.
See Barro (1986) and Backus and Driffill (1985). Blackburn and Christensen (1989) survey the literature. See also Persson and Tabellini (1990) for a comprehensive review of the literature on time inconsistency and modern political economy.
The credibility and financing arguments for external intervention are not the only possible explanations. Countries can also rely on an external agent to get technical assistance, in fiscal, monetary, or other areas. A different explanation from the public choice literature suggests that governments use external agents as scapegoats and blame them for undertaking painful adjustment programs and other “dirty work.” See, for example, Vaubel (1986).
Garber and Spencer (1992) describe the League’s involvement in Austria and Hungary. This paper emphasizes the enforcement of each of the six reconstruction schemes as a necessary condition to increase the likelihood of the program’s success in effecting a change of regime.
The financing for the refugee settlement schemes was aimed at meeting specific expenses to settle them.
For example, in the two Greek schemes the International Financial Commission, which had been used by foreign creditors since 1898 to control some state revenues assigned as security to foreign loans, continued to function during the period of the League’s involvement. In the case of Danzig, a High Commissioner had already been appointed by the League to reside there, because, according to the Treaty of Versailles, Danzig was made a free city under the protection of the League.
The significance level is 0002. The test was performed by ordering the countries according to their percentage currency depreciation during the period of nonconvertibility (third column of Table 7) and sorting the countries that were above and below the median country. The test then analyzed the relative position of countries with and without external loans with respect to the median countryto determine if their currency depreciation was the same (null hypothesis). Those countries that issued a national currency for the first time (Danzig and Lithuania) were excluded.
Further support for this statement comes from the fact that there was recourse to external loans in all the high-inflation episodes studied by Dornbusch and Fischer (1986).
The Eesti mark of Estonia was stabilized in 1924, well in advance of the 1927 loan obtained by Estonia through the League. It is thus plausible that the external involvement was not anticipated at the moment of the stabilization. Danzig was dropped from the analysis owing to a lack of data for 1923.
The significance level is 0.024.
The same is admitted by the Reparation Commission (as quoted in Bresciani-Turroni (1937, p. 339)).
The degree of external control in the Polish case seems very mild.
Bulgaria and Greece are probably misclassified because they did not exhibit exchange rate depreciations as large as those in the hyperinflation countries. In the case of the Italian misclassification, it is likely due to the substantial fiscal deficit.
Similar results are obtained by running logit regressions instead of the probit specification, as well as by lagging the variables one period instead of using current values.
This performance seems to be compatible with the evidence found by Harberger and Edwards (1980) in their study of modern devaluation episodes. They found that countries that abandoned a fixed exchange rate reacted to a decrease in their equivalent measure of BACK only after it had reached a critical level. A similar scenario in which a critical value of BACK triggers external enforcement of a stabilization program may be possible in this sample.